Tax Bends & Breaks

The Base Erosion and Profit Sharing initiative will make it more difficult for multinationals to shift their tax obligations to offshore locales where they do little business. But some say it could thwart global economic growth and trade.

On June 7 this year, CFOs woke up to a new and less forgiving world of taxation after ministers and high-level officials from 68 countries signed a multilateral convention that updates existing bilateral tax treaties, establishes common reporting standards and progressively eliminates opportunities for tax avoidance. The Base Erosion and Profit Shifting (BEPS) initiative, led by the Organization for Economic Cooperation and Development (OECD) and the G8, was signed by the 28 members of the European Union, including the UK, along with China, Hong Kong, Indonesia, India, Korea, Russia and Singapore. Eight more countries have expressed their intention to sign the convention, .BEPS will make it harder for corporations to locate profits in geographies with favorable tax rates, by requiring that their assignment of taxable income actually aligns to “people activities.” 

Graham Moore, a Hong Kong-based expert on global taxation, argues that BEPS will force a new level of transparency and enable a fairer tax situation, as companies will have to pay what is reasonable based on the size of their establishment. “Large companies, such as Amazon, Apple and Google, have of late been accused of exploiting the disparate tax rules of different countries to structure their businesses and minimize average tax rates—an avenue open only to large companies with the resources to choose how they structure themselves for tax purposes,” Moore explains. “BEPS will greatly reduce avenues for tax evasion,” Moore adds, “such as the hiding of income or profits from tax authorities, as the chances of being discovered will become much higher due to new disclosure rules.”

In an industry like mining, where most employees are involved in the actual extraction of minerals, BEPS requires that multinational corporations (MNCs) no longer report most of their profits in low-tax jurisdictions where few people are based and little real activity occurs. It isn’t surprising that countries like Australia—particularly aggrieved at the deliberate export of profits to low-tax countries like Singapore, has an enthusiastic interest in BEPS, as has China. But some critics argue that BEPS goes too far, cannot be implemented and smacks of protectionism. Political leaders in Singapore, where a major part of the economy is dependent on tax optimization structures, have come out strongly against it.

Four Economists Sat Around A Table

Commencing in October 2015, an effort was launched by the OECD to define a consistent set of global tax rules, providing MNCs with less latitude than they now have to shortchange governments through the artful use of loopholes in national laws. In a November 2016 article, Global Finance described how CFOs overseeing multi-jurisdiction tax reporting make judicious use of these loopholes to reduce aggregate tax liabilities and deliver more profit to shareholders—in some cases stretching both credulity and legality. As a result, some governments have woken up to the fact that they need to police corporate taxes more diligently to ensure that they earn their fair share.

Developing nations, whose tax policies are often less evolved and less well monitored, are especially vulnerable to being deprived of revenue, which in turn leads to less funding of critical public investment to promote growth.

The BEPS action plan aims to minimize these revenue losses by closing existing loopholes and realigning taxation with real economic activity, such as employment, assets and sales.

While its promoters argue that BEPS is the most significant development in tax policy in decades, there are dissenters. Reuven Avi-Yonah, an Irwin I. Cohn law professor at the University of Michigan and director of the International Tax LLM Program, is one of BEPS’ leading critics. He argues that BEPS fails to address what ails corporate income tax. Avi-Yonah contends that the root of the problem lies in the prevailing international consensus, which dates back to a multilateral dialogue held under the League of Nations almost 100 years ago. “Given the lapse of time,” he argues, “we are overdue for a rethink.”

Four economists sat around a table in Geneva in March 1923 and decided on a way of dealing with cross-border profits: Active business income, they surmised, should primarily be taxed in the source country, where the profits were earned, while passive business income should be primarily taxed in the taxpayer’s country of residence.

The rest, as they say, is history. Almost every country’s corporate tax regime is premised on these core principles. Ditto for the OECD tax convention and transfer pricing guidelines, which were covered in this magazine in November 2016, and which are similarly subject to growing scrutiny.

“This international consensus has enjoyed a remarkable run. It has survived the rise of socialism, fascism, the Great Depression, World War II, and the Cold War. But can it survive the era of globalization?” asks Avi-Yonah. He clearly thinks it cannot, and points out that the evidence is all around us. “The consensus is already functionally dead, but policymakers are so deeply entrenched in the orthodoxy they can’t read the writing on the wall. Essentially BEPS is more of the same,” he says.

What’s Wrong With BEPS?

Many argue that BEPS relies on antiquated notions of corporate residence and source of income. The international consensus assumed such matters were fixed and objectively determinable–and for most of the 20th century they were. But in the 21st century, they’ve proven to be malleable constructs. These days, a multinational’s country of residence is wherever the tax department wants it to be.

And profits can be sourced to almost any jurisdiction that offers a favorable after-tax outcome—think of high-value intangibles: The jurisdictions that claim tax rights over their economic returns routinely lack any meaningful connection to where the intangibles were developed or deployed.

BEPS is an effort to more closely align the incidence of corporate taxation with actual economic activity and value creation. But governments outside the OECD club (Brazil, China, India) were never sold on the international consensus in the first place, says Avi-Yonah, “They are amused by our clinginess to jurisdictional tax principles that no longer mesh with reality or adequately protect the public purse,” he explains. “One has to wonder if the next great paradigm shift in global tax policy will emanate from their ranks, not ours. If so, it’s likely to bear little resemblance to BEPS.”

Not unsurprisingly, jurisdictions whose low corporate tax rates make them popular with corporates seeking to optimize shareholder returns are getting antsy at the prospect of their discretion to set tax policy being eroded by global standardization of the kind that BEPS promises.

For a country like Singapore, which is favored by MNCs pursuing tax optimization and has little in the way of indigenous manufacturing, there is a lot to lose.

Recently Josephine Teo, a minister in the Singapore prime minister’s office & second minister for Manpower & Foreign Affairs, openly criticized BEPS and characterized it as “a protectionist measure.” “It is critical for reforms to the global tax system to be carried out in a way that continues to accommodate legitimate business models, promotes global economic growth and trade, and that they should not be used as a disguise for protectionism,” stated Teo speaking at the 2015 Tax Academy & IFA Singapore Asia-Pacific Regional Tax Conference. “Put in another way, even as we tackle harmful tax practices, we must take care to preserve useful and beneficial ones.”

Teo also said that unilateral action by countries to combat BEPS should be avoided, and that Singapore intends to keep its tax burden low to continue to “encourage enterprise, savings and investment in the country.”

Moore says some advisers he knows are worried because there could be cases where advice given in good faith and under current interpretations of the law could, years later, be deemed as tax avoidance and therefore illegal. “BEPS means a new world of risk for corporates and their advisors,” he says.